Trading in the secondary market for U.S. government securities has, for many years, been conducted in accordance with a trading convention referred to as “workup.” This convention permits buyers and sellers to “work up” the size of a trade from an initial transaction quantity.
Over time, a number of distinct workup protocols have developed and been implemented by inter-dealer brokers operating in the secondary market. These include a workup protocol developed by BrokerTec USA, LLC and in use on the BrokerTec electronic trading network (ETN). In this workup protocol, an initial “hit” or “lift” by an aggressive trader commences a workup and triggers a first phase, called the “private phase.” During the private phase, only orders of the aggressor (if the aggressor hits or takes all available size at the best price) and the first passive participant that was hit or lifted may transact. The orders of all other participants are queued but not executed.
When the private phase expires, a second workup phase begins, called the “public phase.” During the public phase, the orders of all traders are executed on a time priority basis. After conclusion of the public phase, the workup ends and a new bid-offer market is presented to the traders.
The BrokerTec ETN is adapted to receive different types of aggressive orders called “Fill or Kill” (“FoK”), “Fill and Kill” (“FaK”), and “Fill and Store” (“FaS”) orders. A FoK order is executed only if it can be completely filled. Thus, for example, if a trader submits a FoK order to buy 10 M of a particular security at par and only 8 M of that security is available at that price, no trade occurs and the order is “killed,” i.e., not entered in the system's order book.
By contrast, FaK and FaS orders may be partially filled. When a FaS order is partially filled, the unfilled portion of the order is automatically converted to a new order for the unfilled size and added to the system's order book. When a FaK order is partially filled, the unfilled portion of the order is “killed” and does not result in an order for the unfilled size being placed in the system's order book following the workup.
For purposes of illustration, the system and method described herein will be primarily described in connection with the BrokerTec ETN workup protocol described above. It should be recognized, however, that the principles and concepts of the present invention may be applied more generally in connection with other workup protocols.
Workup has traditionally been justified on the ground that it provides certain benefits to market participants. These include permitting a dealer to maintain the secrecy of its trading strategy by posting a small bid or offer, rather than the true amount the dealer wishes to buy or sell. Once the quote is accepted by a second dealer, the original dealer can increase the amount or “work up” the amount of the initial quote to the point where it reaches the amount the dealer truly desired. In this way, the dealer can avoid posting a large bid or offer in the first instance, which could potentially cause the market price to rise or fall significantly. The workup convention has also traditionally allowed participants to limit expected costs or losses with respect to stale quotes. One example of this practice working to the advantage of a dealer occurs when the market moves rapidly and the dealer is on the wrong side of the market price, i.e., the dealer has posted a low price for a security when the market price has increased for that security. By placing an order for an amount of the security lower than the amount actually desired, the dealer's loss on the transaction is limited because the dealer is not obligated to trade any additional quantity at a disadvantageous price.
Workup pre-existed the introduction of electronic trading systems and has long been part of standard trading in certain markets, such as the secondary market in U.S. Treasuries. But in most other markets, first-in-first-out (“FIFO”) trading protocols are the standard model. FIFO protocols allow order queues to build based on the price and time that orders are placed, and all orders are matched on a first-come-first-served basis. A trader whose order initiates a trade is given no privileges. Some examples of markets that utilize a FIFO protocol include NASDAQ's electronic communication networks (ECNs), Island, Supermontage, Instinet, and Brut.
As the user community of electronic systems that trade U.S. government securities has increased to include traders used to trading in other markets, these new users have found it difficult to accept a workup protocol and prefer, in many cases, a FIFO protocol. At the same time, there are many users who are adherents to a workup protocol and reluctant to change to a FIFO protocol. Although it is possible to satisfy both groups of traders by providing separate FIFO and workup markets for the same security, this solution is not optimal because it splits the liquidity in the security into two distinct pools.